Escolar Documentos
Profissional Documentos
Cultura Documentos
By Rustom Barua, Fabio Battaglia, Ravindran Jagannathan, Jivantha Mendis and Mario Onorato
Table of Contents
1. 2. 2.1. 2.2. 2.3. 2.3.1. 2.3.2. 2.3.3. 2.3.4. 2.3.5. 2.3.6. 2.3.7. 2.3.8. 2.4. 2.4.1. 2.4.2. 2.4.3. 3. 3.1. 3.2. 3.2.1. 3.2.2. 3.2.3. 3.2.4. 3.2.5. 3.2.6. 3.2.7. 3.2.8. 3.2.9. 3.2.10. 3.2.11. 3.2.12. 3.3. 3.4. 3.5. 4. 5. 5.1. 5.2. 6. 7. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 Liquidity Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 The Regulatory Effort . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 The New Liquidity Requirements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 The New Liquidity Ratios: Tasks and Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Insufficiency of Standardized Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Building Differentiated Incentives to Traditional Banking vs. Speculative Trading . . . . . . . . . . . . . .10 Accounting for Banks Size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 Need to Raise New Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .11 Securitization Disruption . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .12 Raising New Medium/Long-Term Finance (NSFR) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .13 Distorting Bond Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14 Reshaping Interbank Deposit Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .14 Survival Horizon Models: Optimizing the Liquidity Buffer in a Comprehensive Risk Management Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15 The Relationship between the Basel Ratios and Bank-Specific Survival Horizon Models . . . . . . . .15 Calculating the Amount of the Liquidity Buffer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16 Optimising the Liquid Asset Buffer . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17 Proposals Regarding Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18 Capital Base . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18 Risk Coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19 Addressing General Wrong-way Risk Stressed EEPE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19 Capturing CVA Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20 Specific Wrong-way Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21 Higher Risk Weights for Financial Institutions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21 Increase Margin Period of Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22 Preclude Downgrade Triggers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .22 Collateral Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 Central Counterparties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 Stressed PDs for Highly Leveraged Counterparties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 Stress Testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24 Back Testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24 Reduce Reliance on External Ratings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24 Leverage Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .25 Counter-Cyclical Capital Buffers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27 Systemic Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .31 Implementation Timelines . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .32 Business impact and challenges: exploring the interplay between Liquidity and Capital . . . . . . .32 Exploring Interconnections and Trade-Offs between Capital and Liquidity . . . . . . . . . . . . . . . . . . . .34 Misunderstanding How Liquidity Risk and Capital are Connected . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35 Technology Direction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .36 Conclusion: Moving Towards a Holistic System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 REFERENCES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40
1. Introduction
An extensive effort is underway to strengthen the financial sector and make banks and other institutions more resilient in the face of unexpected stress.The hope is that any future crisis will not lead to governments again being forced to spend billions of dollars of taxpayers money saving the banking system. In terms of regulatory requirements, this effort has been concentrated in proposals envisaging three areas where constraints are being substantially overhauled: regulatory capital, liquidity and leverage. These proposals were summarized in two Consultation Papers issued by the Basel Committee on Banking Supervision (BCBS) In December 2009: Strengthening the Resilience of the Banking Sector, dealing with regulatory capital and leverage. International Framework for Liquidity Risk Measurement, Standards and Monitoring, addressing liquidity requirements. The urgency of the tasks was expressed by Mario Draghi, the Chairman of the Financial Stability Board, in his Letter to the gathering of G20 world leaders in Toronto. Published on June 27th, 2010, it read:It will be important that Leaders support calibration of the new capital, liquidity and leverage standards to a level and quality that enable banks to withstand stresses of the magnitude experienced in this crisis, without public support. The quality and amount of capital in the banking system must be significantly higher to improve loss absorbency and resiliency.We should provide transition arrangements that enable movement to robust new standards without putting the recovery at risk, rather than allow concerns over the transition to weaken the standards . On July 26, 2010 the Bank for International Settlements (BIS) announced that the Group of Governors and Heads of Supervision, the oversight body of the Basel Committee, had reached a broad agreement on a capital and liquidity reform package. This resulted not only in a significant easing of the rules compared to the first draft, but more importantly in a substantial delay in their effective implementation. For the leverage ratio and the net stable funding ratio, which had been concerning banks most, transition periods were established such that the new rules will not come into force until 2018. Jean-Claude Trichet, President of the European Central Bank and Chairman of the of Governors and Heads of Supervision, made clear that this delay is aimed at avoiding the possibility of the new constraints hitting the global economy while a difficult recovery is in course: We will put in place transition arrangements that ensure the banking sector is able to support the economic recovery1. The BIS communiqu stated that the Governors and Heads of Supervision had taken account of the results of the quantitative impact study undertaken by the Basel Committee to assess the potential impact on bank profitability and the broader economy of the new rules.The results of this study will be published by the Committee later this year. At its 12 September 2010 meeting, the Group of Governors and Heads of Supervision fully endorsed the agreements reached on 26 July 2010. These capital reforms, together with the introduction of a global liquidity standard, deliver on the core of the global financial reform agenda and will be presented to the G20 Leaders summit taking place in Seoul in November.
Bank for International Settlements,The Group of Governors and Heads of Supervision reach broad agreement on Basel Committee capital and liquidity reform package, Press Release, 26 July 2010.
The agreement was widely seen by the market as good news for banks, and bank shares worldwide spiked. Banks will still be allowed to recapitalize through retained earnings rather than fresh capital and will push back into the future the downwards pressure on profits that would result from the obligation to hold greater amounts of capital, liquid assets and medium/long-term debt. However, concern was expressed by commentators as to the effectiveness of such a long transition in view of system protection.We could also question whether European supervisors have fully taken advantage of lessons from the crisis. The above winon July 26 for banks came just days after the European Central Bank released the results of the stress tests conducted on a significant sample of European banks.The tests showed that most of these would be capable of withstanding a significant and protracted stress. However, the tests focused on capital levels only and did not test banks for liquidity risk.This persistence of a siloapproach to risk management is, in our view, to be seen as a weakness. There is significant evidence from the crisis that interdependence among risks cannot be dismissed and that unexpected fallouts in terms of liquidity can put financial institutions at extreme risk.We will outline in the last part of this document that the siloapproach should be completely overcome in favour of an integrated view of different risk types that duly considers interdependencies among risks. This paper will focus on the current version of the new Basel requirements on capital, liquidity and leverage as amended after the 26 July communiqu and ratified on September 12, 2010. It will analyse implications, issues and interconnections between them and discuss some of new trends in best practice of banks risk management and capital optimization that are likely to emerge as a result. The enhanced set of rules has been widely referenced in the industry as Basel III When the Basel II Accord . was finalized in 2004 the assumption was that the overall quality and quantity of capital was sufficient, but the BCBS wanted to make the regulatory capital measure more risk sensitive. Current discussions on Basel III intend to achieve better quality capital as well as increasing the amount of capital. In this document we will first describe the liquidity risk rules and potential shortcomings in Basel III. In section 3 we describe changes to capital requirements, with special emphasis on risk coverage, leverage ratio and countercyclical capital buffers. In section 4 we summarize the implementation timelines as specified in the September 12,2010 press release.Section 5 describes the potential business impact for global banks and explores the interplay between capital and liquidity. Section 6 is our view of how enterprise risk technology will evolve over the next few years.We conclude with section 7 on how business processes and systems are moving towards a holistic, integrated risk management framework.
2. Liquidity Risk
After being neglected for decades,liquidity risk has suddenly taken centre stage thanks to the financial crisis. As a result a continuous flow of new best practice guidance and supervisory requirement documents have emerged over the last couple of years. Such a stringent approach to liquidity risk supervision is indeed rather new in the regulatory framework. In both Basel I and Basel II, liquidity risk received only limited attention. The entire Basel framework only looked at the asset side of the balance sheet. Risks arising from the liability side (including liquidity risk alongside other risks, such as interest rate risk of the banking book), for instance, are not subject to any regulatory capital requirement.They are instead disciplined under Pillar 2, whereby banks are required to undertake the ICAAP (Internal Capital Adequacy Assessment), i.e. a calculation of the amount of capital (called internal capital) they deem sufficient to support all their risks. Pillar 2 requires that the ICAAP include liquidity risk. However, this provision has resulted in an inconsistency: after years of sterile debate on the possible methodologies for calculating internal capital for liquidity risk, it has been generally accepted that capital is not a suitable mitigant for liquidity risk. As a result, the current Basel II framework does not in effect address liquidity risk. At the root of this construction stood a very fundamental assumption, that a bank would always be creditworthy as long as asset quality was preserved. In other words, provided the quality of assets was good enough then a bank would always find finance at fair prices, for virtually any amounts. This assumption proved completely wrong when the crisis erupted and entire liquidity channels suddenly dried up, such that even institutions with high ratings and excellent asset quality found themselves trouble as a result of liquidity mismatches. This phenomenon grew to systemic proportions since many in the industry had been massively leveraging maturity mismatches between assets and liabilities as a key component of an extremely profitable business model. Liquidity risk originates from the mismatch between the timings of cash inflows and outflows. As such, it is fundamentally inherent to the banking business. In fact, one of the key functions of the banking industry in a modern economic system is to allow the reallocation of financial resources from the liquid sectors (those which have excess financial resources to invest) to the illiquid ones.This entails two consequences: 1. The banking industry is necessarily exposed to a maturity mismatch. Typically, the term on which liquid operators are ready to invest their liquidity is shorter than that on which illiquid operators are willing to borrow. While reallocating financial resources from one sector to the other, the banking system bears such mismatch of maturities in the form of liquidity risk. 2. The banking industry is a leveraged one. Its business is borrowing money from excess sectors and lending it to sectors in need. Banks inherently work on others money. Obviously, a high leverage boosts the impact of any liquidity problem, both on an individual and a system basis. As a result, regulators cannot aim to remove mismatch liquidity risk from the system. One individual bank could theoretically fund itself such that all maturity mismatches are hedged, but this is impossible at the system level. Regulators are therefore trying to cope with the problem the other way around: forcing banks to build liquid reserves such that, while not matching outflows in terms of maturities, they ensure that if a stress occurs then banks can withstand cash imbalances until the situation returns to normality.
According to a McKinsey survey on European banks4, the impact of the liquidity ratios in their current versions is estimated as follows: LCR: increase in liquid asset holdings in the region of Eur. 2 trillion. NSFR: increase in long-term funding (>1 year) in the range of Eur. 3.5 to 5.0 trillion (this compares to current outstanding long-term unsecured debt of Eur. 10 trillion). As to banksprofitability,McKinsey provides an estimate that covers both the liquidity ratios and the proposed tougher requirements on capital.McKinsey expects that the return on equity (ROE) of the banking sector in Europe could decline by 5% compared to its long-term average of 15% At the end of the G20 meeting in Toronto, Jaime Caruana, General Manager of the Bank for International Settlements, tried to reassure banks that the new rules will not undermine economic growth and will , 5 only have a small and temporary effect on demand . Basel Committee representatives mentioned that estimates such as those quoted above could be excessively pessimistic, particularly on the basis that they do not sufficiently account for the dynamics of the financial system and the behavior of its operators. Investors are likely to require a lower return on capital as a result of the perception of a lower risk. Also, banks are likely to build new products designed to match the more stringent regulatory requirements in terms of both capital and medium/long term funding, and to smoothen the impact of new regulation on costs.The recent announcement by Unicredit, the third largest European bank by market value, of a new hybrid product designed to match the new capital eligibility requirements is an example in this direction.
2 3
See Mario Draghi, Chairman of the Financial Stability Board, Letter to the G20 Meeting in Toronto, July 2010 Institute for International Finance, Interim Report on the Cumulative Impact on the Global Economy of Proposed Changes in the Banking Regulatory Framework, June 2010 4 Basel III: What the draft proposals might mean for European banking, McKinsey on Corporate & Investment Banking, Summer 2010 5 The Financial Times, Move to reassure banks on tough rules, 5 July 2010
Nevertheless, the regulatory effort is extremely delicate. The regulators are moving across unknown ground and it is difficult to assess the potential outcome of the new constraints.The decisions stated in the BIS 26 July statement, which defined very long transition periods for the newest and most challenging subset of the new planned requirements (the Leverage Ratio and the Net Stable Funding Ratio), are a clear sign of this. By delaying the new regulations until after a full economic cycle has taken place, supervisors want to avoid them hitting economies while a difficult recovery is taking its course, while at the same time creating the space to assess their potential impact on all the phases of the cycle.
The NSFR requires banks to have enough funding to last at least one year to compensate for all cash needs expected to occur beyond the same deadline: Available Amount of Stable Funding >= 100% Required Amount of Stable Funding Available Amount of Stable Funding is made up by cash, equity and liabilities which are expected to remain with the bank for at least one year, either because they have a longer contractual maturity,or because they can be considered stickyeven if their contractual maturity falls within that year (as is the case, for instance, for a share of retail deposits). Required Amount of Stable Funding is the amount of assets that are not expected to be reimbursed for at least one year (and therefore need to be funded for at least this period) and cash outflows expected to occur beyond one year as a result of contingent liabilities. As well the LCR, the NSFR is calculated by aggregating a banks assets and liabilities (including contingent liabilities) into standardized categories and applying a set of coefficients reflecting standard scenario assumptions regarding, for instance, the stickiness of the banks deposit base. No favourable treatment is envisaged for the following instruments, for which banks must therefore have 100% Stable Funding: - Securitizable assets. - Assets from securitizations (unless for covered bonds). - Securities issued by banks or other financial institutions. - Any security with rating lower than A-. Monitoring tools: in addition to the ratios, the Committee has listed a set of monitoring metrics that should be considered as the minimum types of information supervisors should use in their monitoring activity.These include: - Contractual maturity mismatch. - Concentration of funding. - Available unencumbered assets. - Market-related monitoring tools: asset prices and liquidity, CDS spreads, equity prices, etc.
Basel Committee for Banking Supervision, Principles for sound liquidity risk management and supervision, September 2008
Solid funding ratio Before-Crisis contributes to shareholder value creation After-Crisis Selected global banks in developed markets
After-Crisis SPI (Aug 07-Dec 08)
400 200 0 -200 -400 -600 -800 -1000 -1200 0.25 0.65 0.50 0.75 1.00 Industry average
10
The task of providing differentiated incentives for traditional banking as opposed to more speculative financial activity is apparent in how the Committee has addressed the new requirements for capital and leverage. Here, more speculative instruments such as derivatives (especially if traded over-the-counter) are subject to much higher capital requirements. Also, in the current formulation of the leverage ratio a variety of derivatives are fully considered as assets to be accounted for against capital, and netting of derivatives is in principle forbidden. When we come to the liquidity ratios, however, such differentiation of incentives is less clear. Indeed, the BIS has shown it will to move in this direction in the 26 July document by defining a more favourable treatment of deposits from retail and small to medium-size enterprises both in the LCR and the NSFR, and of mortgages in the NSFR. Nevertheless, we believe the incentive to traditionallending could be further enhanced. For instance, loans with maturity below one year severely impact the required amount of medium/long-term funding, as it is assumed that banks will be forced to roll over beyond the one-year horizon 85% of such loans if granted to retail clients, and 50% if granted to non-financial corporations. In our view, this penalizing assumption could be smoothed. Also, conditions could be defined under which a more favourable treatment in the NSFR is allowed for medium/long-term maturity assets that are bound to be securitized in the short run. We will address securitizations in a dedicated section later in this document.
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If banks are not able to raise new capital in the amounts required then the only alternative would be to reduce assets.This could hit the broader economy by capping the amount of credit available to it. This undesired impact would be exacerbated in the context of a constrained leverage ratio, whereby liquid assets are fully considered in the calculation of total assets to be put against capital as per the current proposal from the Basel Committee. Indeed, this provision does not appear to be fully justified in theory and could in our view be lifted.This would allow banks using borrowed resources to fund the liquid asset buffer, and would therefore grant them a greater degree of freedom in making strategic decisions about the amount of credit available for clients.
12
This type of requirement is not new in liquidity risk supervision.The Bank of Italy required for some years local banks to comply with the so-called Maturity Transformation Rule that implied a limitation on the possibility to get exposed to maturity mismatches.This rule was lifted some years ago, well before the , start of the crisis.
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2.4. Survival Horizon Models: Optimizing the Liquidity Buffer in a Comprehensive Risk Management Framework
Despite survival horizon, or survival period, models not being expressly included by the Basel Committee in its list of mandatory metrics banks are required to use in liquidity risk assessment, they are gaining space among supervisors for their ability to provide a synthetic indicator of a banks resilience against liquidity stresses. The LCR is in fact based on a survival horizon model with a 30-day observation period and standardized stress assumptions. Australias regulator, APRA, in 2009 released a consultation paper where it envisaged a new regulatory regime for liquidity risk, including an obligation for banks to provide survival horizon analysis10. The UKs regulator, the FSA, while not expressly imposing SH-modeled reporting, did disclose during public hearings that it will use banksreported figures to feed SH models in order to assess their resilience against stress. Survival horizon models are based on a comparison of forward liquidity exposure, i.e. the sum of expected cash flows over a defined period, to the amount of cash that the bank can expect to raise by selling or pledging its liquefiable assets over the same period.Both terms of the comparison are made subject to stress assumptions of defined severity.The survival horizon is the period over which the existing liquid or liquefiable resources are sufficient to support all expected cash outflows under the defined stress assumptions. Survival horizon models are effective in delivering a synthetic indicator of a banks resistance to stress, after integrating the potential impact of different kinds of liquidity risk (e.g. market and funding liquidity risk) and a variety of scenario assumptions. As such, they lend themselves to providing a single measure that can be used as a reference for the definition of the banks risk tolerance.
2.4.1. The Relationship between the Basel Ratios and Bank Specific Survival Horizon Models
The new liquidity ratios will have a key role in defining banks strategies: - The Liquidity Coverage Ratio will determine the minimum amount of liquid assets given expected cash flows over the short run (unless the results of bank-specific stress tests mandate holding greater amounts of liquid assets). - The Net Stable Funding Ratio will determine the minimum amount of medium/long term funding given capital, medium/long lending business and contingent liabilities. The need to hold substantially greater amounts of liquid assets will oblige banks to switch part of their investments from more profitable assets to high-quality, typically low-yield instruments. This trade-off might be further emphasized by the envisaged leverage ratio: in the current proposal, liquid asset holdings are fully taken into account in the calculation of the leverage ratio although the Basel Committee has stated it might consider, after proper impact assessment, excluding certain categories of liquid assets from the calculation of the leverage ratio. However, Basel Committee documents make it clear that the regulatory ratios should not be seen as absolute. Individual requirements for liquid asset holdings must be defined after the results of individual stress tests, and the regulatory ratios should rather be seen as a regulatory minimum.
10
APRAs prudential approach to ADI liquidity risk, Discussion Paper, 11 September 2009
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Therefore, the required amount of liquid assets should be defined as the maximum of the results of the regulatory ratios and the amount resulting from individual stress testing. Bank-specific stress tests should be based on assumptions designed to match the banks specific context, business model and vulnerabilities.As such,stress tests should tend to stress business strategies and business models rather than external risk factors.We would mention reverse stress testing as a particularly suitable technique for this task.
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The above schematic only refers to a fraction of the overall process.Indeed,both the Basel Committee and the Committee of European Banking Supervisors (CEBS) guidance documents make clear that internal processes need to ensure full consistency and integration of risk tolerance definition, stress testing, risk monitoring and control, and decision making to prevent risk from climbing above the defined risk appetite thresholds. The following summary figure provides a schematic:
Risk Tolerance Policy Stress Test Liquid Asset Buffer Survival Horizon
Early Warnings
Limits
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Committee of European Banking Supervisors, Guidelines on Liquidity Buffers & Survival Periods, 9 December 2009
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Example: Assume a banks risk tolerance policy sets the survival horizon at one month.To assess whether the liquid asset buffer is sufficient for this task, the bank compares the current buffer to the net of cumulative cash inflows and outflows over 30 days under the internally defined stress assumptions. Assume however that a big cash outflow is expected on day five, and an equally big cash inflow is expected on day 29. In the cumulative 30-day cash flow projection the two flows will offset each other so that the spike in cash needs on day five will remain hidden. As a result, the buffer may prove insufficient to cover the cash requirement on days five to 29.
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With a view to improving the transparency of the capital base, financial institutions would be required to disclose all components of the capital along with the regulatory adjustments. In addition, banks are required to provide a reconciliation of the regulatory capital elements back to the audited financial statements. A stricter definition of capital will make it more expensive as well as be a binding constraint in business decision making.
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BCBS has realized some of the shortcomings of the bond equivalent approach and is addressing some of the issues.The July 2010 communiqu was encouraging as it will allow the bond equivalent approach to address hedging, risk capture, effective maturity and double counting, although it is lacking in detail. It is encouraging that BCBS has mentioned addressing double counting, as we encounter that in many places in the document and this needs to be revised to ensure the rules are internally consistent. BCBS has indicated that it will undertake a more fundamental review of the trading book and look at more advanced alternatives to the bond equivalent approach.We hope this will lead to full approval of internal CVA methodology and systems.
21
In the Basel II internal ratings-based (IRB) formulas,AVC is used to capture the default risk part of capital, and the maturity adjustment captures the migration risk. The justification given by BCBS is that ...financial institutions credit quality deteriorated in a highly correlated manner.... If the intention is to capture migration risk, it is best captured either by a modified maturity adjustment or through the CVA.To increase the correlation value increases the default losses and not the migration losses.This is another instance of potential inconsistency in the proposals.
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Taken together, this approach would result in a strong treatment for OBS items. It would also strengthen the treatment of derivatives relative to the purely accounting based measure (and provide a simple way of addressing differences between IFRS and GAAP).
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c) Since the leverage ratio proposed by the Basel Committee is non risk sensitive, it discriminates against safer assets and liabilities. In fact less risky assets which usually also have lower returns will become less attractive, some of the most important examples being mortgages and credit provision to small and medium-sized enterprises. Banks that are facing the limits of the leverage ratio will have an incentive to take on riskier assets that provide higher returns, effectively increasing the risk appetite of the institution as a result of balance sheet constraints that need to be taken into account alongside the risk management considerations.In particular, a differentiated adoption of Basel constraints across jurisdictions could prevent a competitive level playing field in terms of competition. Asset portfolios of banks that have fully adopted the Basel II framework (and therefore are using a risk sensitive approach for capital requirements purposes) are generally less risky compared to the non Basel II compliant banks. Consequently, often the Basel II compliant banks have a higher leverage ratio to compensate for the lower revenue that is a consequence of having safer assets on the balance sheet.These banks, in their attempt to optimize their balance sheet in terms of risk, will decrease the leverage ratio. But at the same time, in order to maintain the same expected returns, they will have an incentive to invest in riskier assets. This is certainly an unwelcome outcome that the Basel Committee should monitor carefully. d) Moreover, the fact that no specific elements of different business models are taken into account by developing only a single indicator is a major weakness in the concept.The leverage ratio will impact the business model of the bank on an integral basis. As the other proposals of the Basel Committee pertain to an array of different areas, the overlaps with the leverage ratio will be numerous.In our opinion,the only way to properly assess the impact of the leverage ratio is to see it in an integrated way with all the other proposals, including those regarding the framework for liquidity risk. It is now clear that this compartmentalized approach, with add-ons to meet minimum regulatory requirements, is seriously flawed.With the emergence of Basel III we have an opportunity to reverse the trend towards splitting risk into different silos. However, we are concerned that the new rules could again fail to produce a framework that refutes the compartmentalized way of thinking. This is seen in the way the Basel Committee is addressing liquidity risk, and specifically in the lack of recognition of the connections between leverage ratio, capital requirements and liquidity buffer. e) Last, but not least there is a possibility that lending would shift from regulated banking to less regulated financial institutions.The unwelcome result will likely be that in periods of financial distress most of the risk that apparently will sit in these financial institutions will turn back to the banking organizations that were indirectly subsidizing the less regulated financial institution. What we have learnt during the recent crisis is that and this is also important from a reputational perspective what ultimately matters is from where risk has originated, which of course will lead to the same answer: in the banking system.
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13
The issue of procyclicality was specifically addressed by the BIS in the Working Paper:Countercyclical capital buffers:exploring options,published on July 22,2010.
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To assist the relevant national banking regulators in each jurisdiction in making buffer decisions, the BCBS developed a methodology to serve as a common starting reference point. The methodology transforms the aggregate private sector credit/GDP gap into a suggested buffer add-on, with a zero guide add-on when credit/GDP is near or below its long-term trend and a positive guide add-on when credit/GDP exceeds its long-term trend by an amount which suggests there could be excess credit growth. The BCBS noted, though, that national authorities are not expected to rely mechanistically on the credit/GDP guide, but rather are expected to apply judgment in the setting of the buffer in their jurisdiction after using the best information available to gauge the build-up of system-wide risk. In the latest September press release the Basel Committee agreed that a countercyclical buffer within a range of 0% 2.5% of common equity or other fully loss absorbing capital will be implemented according to national circumstances. The purpose of the countercyclical buffer is to achieve the broader macroprudential goal of protecting the banking sector from periods of excess aggregate credit growth. For any given country,this buffer will only be in effect when there is excess credit growth that results in a system-wide build up of risk. The countercyclical buffer, when in effect, would be introduced as an extension of the conservative buffer range. Please see last section of this paper for an overview of the agreed detailed implementation timeline. There is a general consensus on the need for stronger counter-cyclical capital buffers to be part of the Basel capital framework. This is clearly a powerful and necessary starting point. However, the challenge lies in the calibration of the parameters when trying to implement in practice this generally agreed objective. We have identified several design issues that we believe deserve further attention by the committee14: 1. Which approach to follow in determining the counter-cyclical capital buffer: discretionary, rule based or mixed? 2. What are the most appropriate policy instruments to introduce counter-cyclicality? 3. Is there a need for a counter-cyclical liquidity measure? 4. What is the most appropriate accounting treatment of a counter-cyclical capital reserve? 5. How do you provide disincentives for the (mis)use of financial innovation and tighten counter-cyclical rules for financial institutions that extensively use it? 6. How do you avoid regulatory arbitrage associated with the introduction of a countercyclical regulatory capital measure? 7. Does size and correlation matter during systemic crisis? 8. Is there a need for a holistic balance sheet management approach? After a detailed analysis of possible alternative methodologies that can be used in determining the counter-cyclical capital buffer, three approaches seem to emerge so far: i. The discretionary approach. ii. The rule-based approach. iii. A mixture of the two.
14
More details on this topic can be found in the Algorithmics response to the Basel Committee on the countercyclical capital buffer.
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With a discretionary system, bank regulators would need to judge the appropriate level of required capital ratios in light of analysis of the macroeconomic cycle and of macro-prudential concerns. It would depend crucially on the quality and independence of the judgments made. Using a formula-driven system, the required level of capital would vary according to some predetermined metric such as the growth of the balance sheet.The Turner and other (e.g., Geneva) reports make the case that there is merit in making the regime, at least to a significant extent, formula driven.This could be combined with regulatory discretion to add additional requirements on top of the formula-driven element if macro-prudential analysis suggested that this was appropriate. We believe this is the right approach to follow. There are several options that have been analyzed in different consultative papers, research papers and international reports (see references at the end of this document) regarding instruments that can be used as a counter cyclical buffer.We believe that the right way forward is to consider a combination of instruments. At a minimum we believe that any countercyclical buffer rules should consider an increase on capital requirements, as currently outlined in the July consultative paper.The buffer must be able to absorb losses on a going concern basis. Consequently, the buffer must comprise the highest quality capital, most likely equity and retained earnings. Also, to avoid regulatory capital arbitrage, as we will describe in the subsequent sections, we recommend that further countercyclical measures be added, in particular: A cap on leverage15 and A capital multiplier if significant currency or maturity mismatch is found As solvency and liquidity are complementary, these rules should be implemented jointly, which would imply requiring more capital in a counter-cyclical way for institutions with large maturity mismatches. However, as capital will never be enough to deal with serious liquidity problems, there is a clear case for having a counter-cyclical liquidity requirement as well. As the U.S.Treasury September 2009 Report argues, excessive funding of longer term assets with short term debt by a bank can contribute as much or more to its failure as insufficient capital. Furthermore, the report states that liquidity is always and everywhere a highly pro-cyclical phenomenon. Indeed, because capital, even though high, may be insufficient to deal with liquidity problems in a crisis, sufficient liquidity requirements are also very important, and need to be determined simultaneously with the general capital requirements in an integrated/out-of-silos framework. Banks with larger structural funding mismatches, or those that rely on volatile short-term funding sources should be required to hold more capital.This would force the banks to internalize higher liquidity risks as a cost, thus encouraging them to seek longer term funding. The Geneva Report and Warwick Report go further by recommending that regulators increase the existing capital requirements by two multiples, one linked to the growth of credit, and the other to maturity mismatches. The accounting treatment of a counter-cyclical capital reserve is hugely important. As regards to accounting disclosure rules, these should satisfy both the needs of investors and those of financial stability. An optimal approach may be to rely on dual disclosure, where both current profits and losses are reported, and profits after deducting a non-distributable counter cyclical buffer that sets aside profits in good years for likely losses in the future.
15
For a detailed analysis of this topic please refer to the leverage ratio section 3.3
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Financial innovations increase during booms, when new and untested instruments that are difficult to value are introduced.This exacerbates pro-cyclicality, as new, often opaque and complex instruments can hide and under-price risk. Regulators should introduce appropriate model risk capital charges if such instruments are traded, or at least tighten counter-cyclical rules for financial institutions that extensively use them.When new and complex products are originated and then distributed it is non-trivial to understand the interplay between risk classes, regulatory and accounting treatments and how, ultimately, this cocktail will influence and drive the setting up of the overall business strategy.The evolution of the collateralized debt obligation (CDO) market during the credit crunch is a good example of this. Only through a holistic view of the balance sheet is it possible to disentangle and understand if the resulting newbank portfolio is aligned with the overall risk appetite of the bank. The standards proposed in the consultative document can be seen as an effort by the Basel Committee to achieve a higher degree of harmonization among supervisory regimes for countercyclical capital buffer requirements. We strongly endorse this effort. We believe that as much effort as possible should be put into the convergence of local supervisory regimes of capital and liquidity risk supervision. To avoid regulatory arbitrage, the comprehensiveness of counter-cyclical regulation is an important issue, both nationally and internationally. The best approach utilizes equivalent comprehensive counter-cyclical regulation for all institutions, instruments, and markets.This would include also all non-banking financial institutions, such as hedge funds, private equity, insurance companies etc (the so-called shadow banking system), as well as all instruments within banks by consolidating all activities onto the balance sheet. It should also include counter-cyclical margin and collateral requirements on all securities and derivatives instruments. Having different capital buffers in different jurisdictions will contribute to differences in cost of capital. This might encourage regulatory arbitrage where multi-national companies will borrow from the cheapest jurisdiction that has a lower counter cyclical buffer to finance activity in other jurisdictions. The emphasis that the U.S. Treasury report and other reports place on higher capital requirements for systemically important institutions draws on research from the BIS and elsewhere showing that large banks,and those more exposed to system-wide shocks,contribute more than proportionally to systemic risks. Both the size of individual banks and the total banking system or even financial system are important, because in crisis situations they may need to be bailed out. In addition to size, bank business models should also be taken into account. For example, a bank largely financing exposures through deposits should have a smaller countercyclical buffer relative to a bank that is completely dependent on wholesale funding. Supervision and business strategy is a multidimensional discipline: increasingly complex balance sheets, opaque structured products embedding unclear leverage and optionalities all make it difficult to gain an overall, timely, transparent and objective view of the interplay among risk types. It is therefore not always clear what exact business strategy is being pursued at a legal entity or even at the holding group level.
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The real problem has become that the resulting overall bank portfolio balance sheet at legal entity level is now very difficult to understand. As a result, communicating the business strategy to the interested internal and external stakeholders, and how this is aligned with the overall risk appetite of the financial institutions, has been, and still looks to be, a challenge. This means that bankers need to use new fit for purpose tools and methodologies that can identify the real risk drivers, their interplay, and the role they play within different legal jurisdictions, accounting, and under differing regulatory treatments. The limitations of the current regulatory, organizational and business silos mindset is probably the biggest and toughest lesson learned from the crisis.We strongly suggest that regulators endorse and gradually introduce, in the spirit and in the letter of the upcoming legislation, this holistic view of the balance sheet, where the interplay of liquidity risk and economic capital is more precisely described. Consequently, we recommend that the impact on the bank and the financial system as a whole be estimated once the stress tests are simultaneously and coherently (same time horizon and severity) executed across all risk types. We believe that the need to simultaneously look at the whole legal entity at balance sheet level (and at its dynamic evolution under stress conditions) from a risk, economic, regulatory, and accounting perspective is not a sophistication but a necessity.
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4. Implementation Timelines
At its 12 September 2010 meeting, the Group of Governors and Heads of Supervision fully endorsed the agreements reached on 26 July 2010. The capital reforms, together with the introduction of a global liquidity standard, deliver on the core of the global financial reform agenda and will be presented to the Seoul G20 Leaders summit in November. Annex 2 of the document, reproduced below, summarizes the key requirements and the required implementation deadlines.
Phase-in arrangements (shading indicates transition periods) (all dates are as of 1 January) 2011 Leverage Ratio Minimum Common Equity Capital Ratio Capital Conservation Buffer Minimum common equity plus capital conservation buffer Phase-in of deductions from CET1 (including amounts exceeding the limit for DTAs, MSRs and financials) Minimum Tier 1 Capital Minimum Total Capital Minimum Total Capital plus conservation buffer Capital instruments that no longer qualify as non-core Tier 1 capital or Tier 2 capital Liquidity coverage ratio Net stable funding ratio
Observation Period begins Observation Period begins
2012
2013
2014
2015
2016
2017
2018
As of 1 January 2019
Supervisory monitoring
Parallel run 1 Jan 2013 1 Jan 2017 Disclosure starts 1 Jan 2015
Migration to Pillar 1
3.5% 3.5%
5. Business impact and challenges: exploring the interplay between Liquidity and Capital
The Basel II Accord,which was ratified in 2004,had as its main objective increasing the risk sensitivity of capital requirements while maintaining the capital amount at a systemic level. Basel II focused on calculating minimum capital requirements and postponed the discussion on capital quality and definitions. It accounted for liquidity risk through Pillar 2, while discussion of liquidity risk had not matured by the time the financial crisis hit.It was liquidity risk that led to the failure of financial institutions like Northern Rock and Bear Sterns. Also, the Basel II accord did not consider leverage in determining the capital requirements of a bank. Some major banks, while being well capitalized from a Basel II perspective, had leverage ratios of 70:1 without taking into account netting (30:1 when netting is taken into account). There was a lot of faith in the risk sensitivity rules under Basel II. However, some of this was misguided.The capital requirements and the risk measurement mechanisms, especially in the trading book, led to regulatory arbitrage. For example, securitization transactions got much more lenient treatment in the trading book versus the banking book, and these shortcomings in the Basel II framework in a way contributed to the capital arbitrage between the banking and trading books and provided incentives for banks to assume high-risk trading strategies. Some of the new rules address these issues. For example, the July 2009 Enhancements to Basel Framework addressed the inadequate capital requirements for securitization transactions,and eliminated the possibility of capital arbitrage from the banking book to the trading book by aligning the capital requirements across the banking and the trading books.
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It is widely believed that the proposed capital and liquidity rules would significantly increase the banking sectors capitalization and funding levels. One study by McKinsey titled Basel III:What the draft proposals might mean for European bankingestimates that the industry would need to raise an additional 40% to 50% of its current Tier 1 capital base.Top 16 European banks will need to raise 700 Billion Euros in capital and 1.8 trillion Euros in long-term funding. It is also estimated the Industry ROE would reduce by about 5% from its current level of 15 %. While the efforts by the Basel Committee are believed to result in lower systemic risk and lower risk for the individual banks over the longer term, the need for the huge infusions of capital in the short to medium term places a huge strain on the capital markets. As investors perceive that current risk in the banking system is high, the required rate of return for any investment in the banking sector will be high. This, viewed along with the lower ROE from the banking industry, and the proposed restrictions on earnings distributions is likely to create a strain in the capital markets till such time the perception of reduced risk in the banking sector sinks in the investors minds. Above estimates assume current bank structures remain the same, but given the scope of the Basel III rules large scale restructuring of bank balance sheets and corporate structures are on the cards.For example, banks might reduce deferred tax assets (assuming profitability over the next few years), sell minorityowned subsidiaries and move away from unsecured interbank funding with larger banking groups. Trading books will almost certainly reduce given estimates that capital might increase about three fold; estimates are high as 20-fold for some banks. Large multinational banks might look more keenly on regulatory arbitrage as capital becomes dearer, by taking into account the differences in regulatory requirements across geographies while deciding the booking location for transactions.As long as regulators allow them,banks will also raise deposits in countries where it is cheapest to fund business in other jurisdictions. The proposed buffers capital conservation buffer and the countercyclical capital buffer are likely to smooth the capital requirement crests and troughs. Under the Basel II regime international banks were fairly well capitalized and regulatory capital was rarely binding. However, with Basel III regulatory capital, and for some large banks leverage ratios and liquidity ratios, will become binding constraints when making business decisions. Currently most banks look at regulatory and economic capital when making business decisions. With Basel III this process becomes more complex. Banks will need to examine the incremental impact of deals on regulatory capital, economic capital, leverage ratios and liquidity ratios, and also how it impacts capital and liquidity buffers. This will lead to fine tuning of RWA in the banks effort for capital conservation. Banks will focus on data quality with a special focus on credit mitigation. Some banks currently do not centrally collect collateral, guarantee and netting data for smaller obligors. Although these counterparties might be smaller, in total this effort will tend to reduce RWA significantly. Also, banks will use credit mitigant optimization routines, where mitigants are eligible across lending facilities to apply the mitigants to minimize total RWA across the lending facility. Similarly, CCF models will also be refined to achieve capital optimization. Although Basel III precludes using rating triggers to reduce EADs in the current period,instituting a rigorous procedure can reduce CCF estimates in future periods as well as reduce losses in the current period.
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As regulatory capital becomes binding, banks will move away from capital heavy sectors to capital light sectors and adjust the business model accordingly. In terms of the product analysis, the capital costs for OTC derivatives, liquidity facilities and short term/long term corporate loans are expected to increase, while the funding costs for OTC Derivatives,fixed income bond investments,covered bonds,liquidity facilities and short term retail loans are expected to increase.Therefore,there will be a move away from these products. For example, retail mortgages get better capital treatment than commercial mortgages. It is noted with interest that although the BCBS has increased capital on the capital markets side of the business, there is no language to require banks to strengthen underwriting procedures for retail mortgages and other retail loans. Regardless, in most countries banks have strengthened underwriting procedures, and strict rules regarding securitizations will reduce the incentive for banks to be lax on this front. This will cut off the vicious cycle of originate to securitize. Basel III is highlighting the integral nature of credit, market and liquidity risk. Before the crisis, most banks appeared to be well capitalized, although they were pushed to the brink due to liquidity risk.The following is a quote from the BCBS,Findings on the interaction of market and credit risk,Working Paper No. 16, 2009: Studies suggest that banksexposures to market risk and credit risk vary with liquidity conditions in the market, and liquidity conditions in turn are also determined by perceptions of market and credit risk. This suggests that banks and regulators need to think about a framework that better integrates all three types of risk. We expect BCBS to smooth out the internal inconsistencies and the double counting in the current proposals before finalizing the rules. The longer implementation framework gives banks and regulators time to optimize the rules as well as not adversely affect the current tentative growth prospects for the economy. In particular, a move towards an integrated framework will let banks examine the impact of different hedging strategies. Some strategies might reduce credit risk but increase liquidity risk, for example. It is imperative that banks gain a holistic view of risk.
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But these are minor advances in addressing a pervasive,deeply ingrained problem.As the banking business has become more complex over the last 30 years, banks in general have tended to take a bottom-up, piecemeal approach to developing risk management functions.When it comes to risk measurement and management, the default option has been for banks to have separate units managing different types of risk. At the same time, as trading and structured finance has become more spread out and complex, the corporate structure of banks has also become more complex, such that different parts of the business run their own profit and loss books. This has made it harder, in general, for managers at the top to have an all-encompassing view of the risks on the groups balance sheet. As risk management has come into its own as a primary discipline within banks, reporting tools and risk management functions such as stress testing have not been integrated across different departments. Systems have been maintained mostly by decentralized IT functions supporting finance, treasury, business lines and risk management. There has been less thought given to reconciling data across systems, which has led to benchmark risk management practices, and ultimately a culture of risk management that has failed to view risk in a necessarily holistic way. A truly effective risk management system would take a top-down approach to risk measurement and reporting, viewing and managing the interconnections between risk factors at a high level, such that their potential impact on the balance sheet can be properly accounted for. It is now clear that this compartmentalized approach, with add-ons to meet minimum regulatory requirements, was seriously flawed.With the emergence of Basel III we have an opportunity to reverse the trend towards splitting risk into different silos. However, as things stand at the moment it seems the new rules will again fail to produce a framework that refutes the compartmentalized way of thinking. This is seen in the way the Basel Committee is addressing liquidity risk, and specifically in the lack of recognition of the connections between leverage, capital and liquidity.The current stress test recommendations, for example, call for the stress testing of liquidity and capital separately. Witness this summers widely publicized European bank stress test exercise. Although the exercise showed that most banks will be able to withstand a significant and protracted period of stress, the tests focused on capital levels only. They completely failed to touch on liquidity risk. If we are to have a robust and truly risk-based framework then the interdependence of capital and liquidity risk must be addressed.One can see the attractiveness of trying to get to grips with liquidity risk by viewing it largely on a stand-alone basis. But this is a mistake. If we are to have a real sense of the nature of liquidity risk, and from there be in a position to put in place systems to effectively manage it, then we must be prepared to engage in the more difficult intellectual challenge of viewing and managing risk holistically.
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The Basel Committees primary response to liquidity risk, the liquidity coverage ratio and the net stable funding ratio, do not recognize this link. As with previous compartmentalized approaches to risk management, these ratios view liquidity risk more or less as a stand-alone risk silo. As such, the implementation of the current approach does not effectively address the flawed silo-based approach. The prescriptive nature of these ratios is not helpful, as it does not allow the tailoring of a liquidity risk buffer to the needs of the specific institution. Under a top-down, holistic risk management model, the senior management of the bank would decide on the size of the liquidity buffer and what survival horizon is appropriate for it, based on a careful assessment of the banks overall risk appetite.This is important from a best practice governance perspective, because if an institution is holding more than the needed amount of liquid assets then the part of the liquidity buffer that is not needed has an opportunity cost associated with it that money could be deployed elsewhere to make a higher return for shareholders. And if the institution holds less than necessary to maintain stability then the bank risks bankruptcy.
6. Technology Direction
Over the last two decades, banks approached risk management from a silo approach across market, credit and operational risk. Basel I was addressed mainly through finance systems. Banks developed market risk systems after the 1996 Amendment. Liquidity risk became a risk discipline only over the past few years. As risk systems grew organically over the years with own data requirements, reporting tools and stress test set ups, they addressed requirements of different departments within the banks. Risk management itself has come into its own as a primary discipline within the banking industry only over the past 15 years or so. Systems were maintained mostly by decentralized IT functions supporting finance, treasury, business lines, risk management etc.There was no thought given to reconciling data across these systems. Spurred by Basel II, larger banks embarked on enterprise data warehouse projects to collect data across trading books, corporate, retail and securitization exposures. However, these systems originally focused on driving credit risk-weighted asset calculations, local regulatory reporting and Basel pillar 3 reporting. Over the last three to four years banks also invested in expanding these data warehouses to cover credit economic capital. Market risk and operational risk were calculated separately and typically brought together at the reporting layer, with manual interventions for regulatory and management reporting purposes under Basel II. With the advent of ICAAP stress test requirements banks needed to examine the impact of a market stress event across risk silos. Banks realized the shortcomings of current systems, but manual aggregation was a practical solution given these stresses needed to be run typically only at a semi-annual frequency. However, the systems are prone to manual errors and find it difficult to cope with ad-hoc stress testing requirements that regulators are now pushing for.
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To address Basel III, banks will need to re-think data and IT strategy.The main drivers will be: The ability to reconcile data across different risk categories.This will lead to a system based on common data inputs to drive market, credit and liquidity risk. Position and counterparty/obligor data should be driven from a single source of truth. A single data load with all the attributes required for market, CCR, RWA, economic capital and liquidity risk should be extracted from source systems. Since this data will be shared across risk types, data reconciliation requirements will be automatically met. Drive the system with common risk factors to enable consistent stress testing across market, credit and liquidity risks. In addition to stress testing, this will also let the bank look at the impact on its capital and liquidity position of changes in assumptions. For example, it would let the bank examine the impact of an increase in the margin period of risk when there are over 5000 transactions in the netting set. Consistent calculation engines that share common models and provide consistent measures across risk types. For example, the pricing models used for market risk valuation purposes should be used for counterparty credit risk simulations. Cash flow generation for liquidity risk should also leverage the cash flow generation routines that should be common to market risk and CCR. On the capital front, using consistent data and models will allow the user to break down the differences between regulatory and economic capital into sources of risk, such as name concentration, sector concentration, migration risk etc. An economic capital model that allows the user to configure economic capital calculations under multiple assumptions (e.g. full granularity, default/no default mode etc) will enable such a breakdown of sources of risk. Integrated reporting across risk types, which is the ultimate aim of the system.This would allow senior managers and investors to get a consistent view across the enterprise of the impact of different types of risk. There will be demand for systems than can perform what-if analysis based on incremental transactions or scenarios. This will enable business users to get a comprehensive view of the risk of incremental trades or hedging strategies. For example, a particular hedge might reduce credit risk but increase liquidity risk. Systems should allow both large volumes, enterprise-wide batch runs while allowing for interactive what-if analysis.This will let the bank examine the impact across market, credit and liquidity risk of incremental deals. It will also let the bank check the impact of new regulations or assumptions such as the margin period of risk. It will make sense for banks to leverage existing investment in Basel II systems to achieve this. Banks that have been successful in building enterprise data warehouses will want to expand them to address Basel III.We see a trend where banks extend the current market risk system for CCR mainly to ensure consistent pricing models. As computation has become cheaper it is feasible to use the same market risk pricing models for counterparty credit risk simulations. At most banks RWA and economic capital systems are now driven by the same data. Liquidity risk covers the enterprise and uses market risk factors for cash flow generation and stress testing. The following table summarizes the current silos of risk types,their scope,risk factors,functionality,measures, confidence intervals and primary functionality.
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Market Scope Trading book assets IR, FX, Equity, Commodity, Volatility etc.
CCR Trading book assets IR, FX, Equity, Commodity, Volatility etc., creditworthiness for CVA PFE at any CI, EPE, CVA
Credit Risk Enterprise assets PD, LGD, EAD, Transition Matrix, Correlation Matrix UL, EL, survival probability
Liquidity Enterprise assets and liabilities IR, FX, Equity, Commodity, Volatility etc., cash flow generation CBC, FLE, LVaR, LCR; NSFR; survival horizon Short Term: daily up to 30-90 days Long Term: yearly up to 15-20 years Non Stochastic Stress Test
Risk Factors
Measures
VaR, IRC
RWA, EL
Time horizon
10-day
1-year
1-year for ICAAP; 3 and 5 year typically for capital planning 99.9% for regulatory purposes; based on risk appetite for internal Additive measures, Reverse stress tests
Confidence level
99%
99.9%
Main functionality
Stress testing
Simulation through time incorporating all credit mitigation including netting, collateral etc.
Undrawn allocation, mitigant optimization, retail pooling, reconciling to GL, stress testing
As can be seen, different types of risks should be driven by common data. Risk types might focus on part of the book or the enterprise, and might need incremental data to drive calculation engines. Providing underlying data from a single source of truth will result in a consistent, reconciled system while providing long term cost savings in terms of reduced manual intervention. The thrust in the future will be towards an integrated risk management platform for regulatory purposes that will allow for ad-hoc stress tests.The original Basel systems for credit risk moved from finance to capital management or risk management due to Basel II. With Basel III, the trend is towards integrated systems moving to enterprise risk groups that will look at risk holistically.
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REFERENCES
1. AlgorithmicsResponse to the Basel Committee's request for comments on the consultative document: Proposed Enhancements to the Basel II Framework, April 2009 http://www.algorithmics.com/EN/media/pdfs/Algo-GC0409-LtrBaselCom.pdf
2. Algorithmics' Response to the FSA's CP 09/13 Strengthening Liquidity Standard 2: Liquidity Reporting, June 2009 http://www.algorithmics.com/EN/publications/whitepapers/registration.cfm?code=wp39 3. AlgorithmicsResponse to the Basel Committees request for comments on the consultative document: International framework for liquidity risk measurement, standards and monitoring, April 2010 http://www.algorithmics.com/EN/media/pdfs/Algo-GC0410-LtrBaselCom2.pdf
4. Algorithmics whitepaper: Towards active management of counterparty credit risk with CVA, 2010 http://www.algorithmics.com/EN/publications/whitepapers 5. Algorithmics whitepaper: Credit Value Adjustment and the changing environment for pricing and managing counterparty credit risk, 2010. http://www.algorithmics.com/EN/publications/whitepapers 6. APRAs prudential approach to ADI liquidity risk, Discussion Paper, 11 September 2009 7. F. Battaglia and M. Onorato, Liquidity Risk: Comparing Regulations Across Jurisdictions and The Role of Central Banks, December 2007; http://www.algorithmics.com/EN/publications/whitepapers 8. F. Battaglia, M. Onorato and S. Good, Liquidity Risk Management Assessing and Planning for Adverse Events, December 2007; http://www.algorithmics.com/EN/publications/whitepapers 9. Basel Committee for Banking Supervision, Principles for sound liquidity risk management and supervision, September 2008 10. Basel Committee of Banking Supervision,Findings on the interaction of market and credit risk, Working Paper No. 16, 2009: 11. Basel Committee of Banking Supervision, Strengthening the Resilience of the banking Sector, December 2009 12. Basel Committee of Banking Supervision, International Framework for Liquidity Risk Measurement, Standards and Monitoring, December 2009 13. Basel Committee of Banking Supervision, Strengthening the Resilience of the banking Sector, Annex, July 26, 2010 14. Basel Committee of Banking Supervision Working Paper: Countercyclical capital buffers: exploring options, published on July 22, 2010. 15. Basel Committee of Banking Supervision, Group of Governors and Heads of Supervision announces higher global minimum capital standard, Press Release, Sept 12, 2010 16. Mario Draghi, Chairman of the Financial Stability Board, Letter to the G20 Meeting in Toronto, July 2010 17. European Banking Supervisors, Guidelines on Liquidity Buffers & Survival Periods, 9 December 2009 18. Financial Stability Forum Report, Addressing Procyclicality in the Financial System. April 2009.
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19. The Financial Times, Move to reassure banks on tough rules, 5 July 2010 20. Geneva Report on the world economy,The Fundamental Principles of Financial Regulation, May 2009 21. Institute for International Finance, Interim Report on the Cumulative Impact on the Global Economy of Proposed Changes in the Banking Regulatory Framework, June 2010 22. McKinsey on Corporate & Investment Banking,Basel III: What the draft proposals might mean for European banking, Summer 2010 23. M. Onorato, A Face-off On Funding: ERM and Liquidity Risk, 2008, TH!NK Magazine; www.algorithmics.com 24. M. Onorato, Liquidity Before and After: The Emergence Of Balance Sheet Risk Management; June 2009, TH!NK Magazine; -Web: www.algorithmics.com 25. M. Onorato, Grasping at shadows: Identifying an effective framework for liquidity risk management, August 2009, GARP Professional; http://www.garp.org/news-and-publications/2009/august.aspx 26. M. Onorato, A Comprehensive Framework For Defining Risk Appetite , forthcoming 2010; TH!NK Magazine www.algorithmics.com 27. Goldman Sachs , Strengthening the Resilience of the banking Sector, Response to the Basel Committee of Banking Supervision from Goldman Sachs, April 16, 2010 28. The Turner Review: A regulatory response to the global banking crisis, March2009, Financial Services Authority. 29. U.K.Treasury Committee. (2009). Banking Crisis: regulation and supervision. July, House of Commons, Treasury Committee, Fourteenth Report of Session 200809, London. 30. U.S.Treasury Department. Financial Regulatory Reform. A New Foundation: Rebuilding Financial Supervision and Regulation. June 2009, U.S.Treasury Department, Washington, DC. 31. U.S.Treasury Department. Principles for Reforming the U.S. and International Regulatory Capital Framework for Banking Firms. September 2009, U.S.Treasury Department, Washington, DC. 32. Warwick Commission on International Financial Reform: In Praise of Unlevel Playing Fields; November 2009 33. Oliver Wyman, State of the Financial Services Industry Report, 2009
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About Algorithmics
Algorithmics is the worlds leading provider of enterprise risk solutions. Financial organizations from around the world use Algorithmics software, analytics, and advisory services to help them make risk-aware business decisions, maximize shareholder value, and meet regulatory requirements. Supported by a global team of risk experts based in all major financial centers, Algorithmics offers proven, award-winning solutions for market, credit, and operational risk, as well as collateral and capital management. Algorithmics is a member of the Fitch Group.
www.algorithmics.com
2010 Algorithmics Software LLC. All rights reserved.You may not reproduce or transmit any part of this document in any form or by any means, electronic or mechanical, including photocopying and recording, for any purpose without the express written permission of Algorithmics Software LLC or any other member of the Algorithmics group of companies. ALGORITHMICS, Ai Logo, ALGORITHMICS & Ai Logo, ALGO, MARK TO FUTURE, RISKWATCH, KNOW YOUR RISK, ALGO RISK, ALGO MARKET, ALGO CREDIT, ALGO COLLATERAL, ALGO FIRST, ALGO ONE, ALGO FOUNDATION, ALGO FINANCIAL MODELER, ALGO OPVAR and TH!NK Logo are trademarks of Algorithmics Trademarks LLC.